Spanish downgrade not seen hitting US debt market, yet

NEW YORK/LONDON (Reuters) - The Standard & Poor’s credit downgrade of Spain last week should have little immediate impact on U.S. money markets, although further downgrades could pressure investors to sell Spanish debt, a J.P. Morgan Securities strategist said on Monday.

Following its downgrade of Spain’s rating by two notches last week, ratings agency S&P on Monday downgraded 11 Spanish banks and warned a further five that their ratings could also be cut.

The downgrade of Spain’s sovereign debt was expected to have no direct impact on U.S. funding markets as “the large Spanish banks have been inactive in the U.S. money markets for nearly a year,” said Alexander Roever, short-term fixed income strategist at J.P. Morgan Securities in New York.

Roever cautioned, however, that any further downgrades could damage Spain’s ability to sell debt and impact markets globally.

“Any more downgrades that would lead Spain to fall into the sub-investment grade category would have large implications for the markets as it will result in Spain being excluded from some bond indices and thereby force passive asset managers to sell,” Roever said.

Spanish banks continued to load up on government bonds in March, data from the European Central Bank data showed on Monday, tying the banks ever closer to their indebted sovereign and raising questions over who will support the government when cheap central bank funding is exhausted.

The value of Spanish banks’ holdings of sovereign bonds rose almost 18 billion euros in March to over 260 billion euros. That is up around 85 billion euros in total since the end of November as institutions invested cheap funds from the European Central Bank’s two three-year liquidity operations, the long-term refinancing operations known as LTROs.

Much of the rise is widely believed to be domestic banks buying their own country’s sovereign bonds, with some of the increase accounted for by changes in market value of the paper.

Spanish government bonds have sold off sharply in April on growing concerns about the country’s ability to meet fiscal targets and its leveraged banking sector.

If Spanish banks continued to be net buyers of the paper in April, it would indicate that selling by international investors was picking up pace.

“The domestic banks stepped in to bridge the gap which was left by a fairly sizeable exodus of non-residential bondholders, which is why the LTRO magic has worn off so quickly,” said Richard McGuire, senior fixed income strategist at Rabobank in London.

Spain sank into recession in the first quarter, data showed on Monday.

And on Friday a government source said banks, rather than the government, would assume the cost of any unprovisioned losses on real estate assets after they are moved into a special holding company.

“We’re still focusing on early cycle losses such as the real estate loans which come to light quite quickly in a downturn,” McGuire said.

“But there’s later cycle losses that we’ve yet to dive into such as corporate loans as the country returns to recession.”

Still, with Spain and other European countries like Italy and Greece on shaky financial ground, the situation remained precarious for Europe as a whole.

“Even though the LTROs have helped to stabilize Europe’s banks and the global interbank markets, they did not fix the underlying fiscal and political issues,” Roever said.

“By swapping cash for collateral, the ECB fed the global liquidity glut that has too much cash chasing too few assets,” he added. “If peripheral sovereign markets continue to deteriorate and political solutions are not reached, palliative central bank responses like further bond purchases or another LTRO eventually could be forthcoming, further feeding the liquidity glut.”